Master limited partnerships and taxes

Eight or 10 years ago, Marie Yen invested in a master limited partnership in her son's college education fund. When her husband did their taxes, the partnership created so many complications he told her never to buy one again.

A few years ago, seeking higher yields than what she could get on traditional investments, she bought some MLPs again, but this time she put them in her individual retirement account, hoping that would solve the tax nightmare since investors don't pay tax on traditional IRAs until they withdraw money, at which point it is all taxed as ordinary income.

Now she's not so sure. "My accountant said I don't need to pay any tax until I take my IRA out later in my life, but other people told me a different story," she says.

At the Money Show in San Francisco last year, a woman representing master limited partnerships said Yen might have to pay tax annually on certain income from partnerships held in an IRA if it exceeds $1,000. Now she is considering selling to avoid that possibility.

Investors like Yen have been flocking to these partnerships in recent years, often without understanding the tax rules, some of which are not entirely clear even to accountants, tax lawyers and the advisers who promote them.

Although they trade like stocks, MLPs are pass-through entities that distribute a proportionate share of the partnership's income, losses, capital gains, interest and deductions directly to shareholders, who are technically limited partners. The partnership itself does not pay tax, like a corporation would (or should).

The partnerships are involved mainly in producing and distributing natural resources, such as operating oil and natural gas pipelines.

They have become popular lately because they yield more than stocks or traditional fixed-income investments. On average, their cash distribution yield is around 6 percent, although that is not directly comparable to the dividend yield on a stock or interest rate on a certificate of deposit. The 6 percent "is partly a return of your capital and partly a return on your capital," says John Brogan, a shareholder with accounting firm Birr Pilger Mayer.

Tax deferral

They are usually recommended for taxable accounts because much of the cash distribution is tax deferred. In the first few years after purchase, most of the distribution is not taxed, thanks to depreciation and other write-offs. In later years, as depreciation wanes, more of the distribution becomes taxable.

The untaxed portion reduces the investor's cost basis, or what he paid for the shares plus or minus adjustments. This portion becomes taxable when the investor sells the partnership.

Here's a simplified example: Suppose you buy an MLP for $100.

In year one, it distributes $6, but you pay tax on only $1.

The untaxed portion, $5, reduces your cost basis to $95.

After a year, you sell it for $102 and pay tax on $7 - the difference between the sales price and your adjusted basis.

The $2 difference between your sales price and original purchase price will be taxed as a capital gain. The remaining $5 will be a mix of ordinary income and capital gains and taxed accordingly.

Each year investors receive a Schedule K-1 that reports their share of the partnership's income, expenses and other items. This complicated schedule can add several hundred dollars to the cost of preparing your tax return.

If the partnership operates in multiple states (most do), you could end up owing income taxes in states where you don't live if your partnership income is high enough.

Not for IRAs

These partnerships "are not recommended for IRAs," says Mary Lyman, executive director of the National Association of Publicly Traded Partnerships. "These are a tax-advantaged investment. If you put it in an IRA, you are wasting the tax benefit. A lot of investors do it anyway so they don't have to worry about the K-1 hassle."

But as Yen found out, holding them in your IRA "doesn't always solve your problem. It may create more problems," says W. Thomas Weir, a tax lawyer in Houston who is familiar with the subject.

Here's why: If you hold one or more of these partnerships in an IRA, some of the distribution you receive will be considered unrelated business taxable income, or UBTI. This amount is reported on the K-1. If it's more than $1,000 in a single year, your IRA will owe tax on it.

Filing by custodian

Your IRA is responsible for paying the tax and filing Form 990-T with the Internal Revenue Service for the year in which it was received. Your IRA custodian (the firm that holds your IRA) is supposed to file the form and pay the tax out of your account, but it's not clear if they always do.

A spokeswoman for Charles Schwab says, "Beginning in tax year 1997, the IRS determined that Schwab, as custodian of these accounts, is required to prepare and file Form 990-T, if the income meets the $1,000 threshold, and remit any tax due. We do not charge to file Form 990-T for the IRA account."

It's not entirely clear if the $1,000 limit applies to a single IRA or to multiple IRAs if you hold them at different institutions. Weir says the regulations indicate that it applies to a single IRA. Connie Vandament, a CPA in Larkspur, agrees.

But Weir sent me a report by Kathryn Kennedy of the John Marshall Law School, published in the BNA Portfolio on IRAs, that says, "An IRA owner must aggregate all of his or her individual accounts to determine if the $1,000 threshold is met." Brogan says, "It is clear that you aggregate."

Investors who pay tax on UBTI from their IRA get no offset for that tax when they withdraw money from the account and pay tax on it. However, "they get a deduction in a sense because if they pay tax to the government, it won't be distributed to them," Brogan says.

It's hard to say how much you could invest in these partnerships before you would start receiving more than $1,000 in UBTI because each one is so different. But the more you buy and the longer you hold them, the more likely you will exceed the limit.

Vandament has prepared many tax returns for clients with these partnerships, and says they seem to do very well. But she wouldn't invest in one personally, "because I hate the complications."